Consumption Tax Definition Example How It Works

What is a Consumption Tax?

Explanation

Upon careful observation of the MRP (maximum retail price) of any product, the break up for the taxes can be seen. Whenever a consumer purchases a product or service in an economy, he/she pays a certain price for the same. This price is inclusive of taxes levied by the government. Value-added taxValue-added TaxValue-added tax (VAT) refers to the charges imposed whenever there is an accretion to a product’s usefulness or value throughout its supply chain, i.e., from its manufacturing to its final selling point. It is an indirect tax levied on the product consumption.read more, sales taxSales TaxThe government levies sales tax on the consumption of various goods and services as the percentage added to the product and services from which the government earns revenue and does the company’s welfare. In the United States, 38 different states have different taxes, from Alaska (1.76%) to Tennessee (9.45%).read more, customs tax, and GSTGSTThe full form of GST is Goods and Service Tax and is levied on the consumption of goods and services. It is a destination-based tax, which means that the tax is paid where the goods or services are consumed.read more is included in the bill; these are considered as consumption tax. It is also known as cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more tax or expenditure tax.While income tax is the tax paid on the earned incomeEarned IncomeEarned income is any amount earned by an individual, such as a salary, wages, or employee compensation. It can also be an individual’s income through their own business.read more, this is the tax on the expense. This tax is regressiveTax Is RegressiveA regressive tax is the system of taxation where all citizens in the country are taxed at the same rate without considering their income levels. As a result, a more significant percentage of the income of the low-income group is charged as tax compared to the high-income group.read more, and accumulation along with deduction will only increase the purchasing power of the consumer

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Features

Each individual who is paying a consumption tax will get a certain amount of exemption and deductions. It is to benefit the poor who have lower consumption power, and they don’t have to pay the taxes.Individuals eligible to pay taxes will not get any sort of deductions as they can save, and these savings would have been already subjected to deductions.The tax payee will be getting exemption from tax on all the incomes placed via investments as the consumption tax only taxes the amount spent or consumption made.Under this, people are taxed based on their consumption patterns and how much they consume instead of how much they contribute to the economy.

How does it Work?

It is a concept from the west slowly making its way in the east. The vendor will collect these taxed from the consumer by charging a higher retail price for the product or service. This tax rateTax RateEffective tax rate determines the average taxation rate for a corporation or an individual. For both, there is a similar formula only with variation in considering variables. The effective tax rate formula for corporation = Total tax expense / EBTread more is different for different products. It is less for basic necessity products, and the percentage is higher for luxury products and services.

Example

It has to be seen from the economy’s point of view. The government will have to collect the appropriate tax from its consumers. While designing the tax rates for each product type, it has to make sure it doesn’t burden or hamper the purchasing power of the consumers.Likewise, basic necessity products are taxed less, and this is compensated by taxing luxury products at a higher rate. Suppose a consumer wants to buy a sports car, the car is levied a hefty luxury taxLuxury TaxThe luxury tax is a tax obtained from people purchasing expensive goods or services that offer luxury and are typically not perceived as essential goods.read more and higher registration amount. In the same economy, if a below poverty line consumer wants to buy his daily needs, the tax is relatively lower.No doubt, if the consumer buying the car will also get his daily needs at the same price but would have paid higher taxes for luxury items.

Consumption vs. Income Tax

Consumption tax is an indirect tax,Indirect Tax,Indirect tax, also known as consumption tax, is the type of tax the person does not directly bear. In contrast, the incidence of such taxes is passed on to the end consumer of goods or services by adding such taxes to the value of those goods or services, like Excise duty, Service tax, VAT, etc.read more tax on the purchase of any goods or services, whereas income tax indirect tax applied on the income earned.
Consumption tax is also called a cash-flow tax or expenditure tax; Income tax is simply based on total income.Consumption tax is different for a different type of products and services, whereas the income tax bracket is the same for all individuals.
No doubt, both are revenue to the government, but consumption tax has to be designed in a way such that neither is it a burden to taxpayersTaxpayersA taxpayer is a person or a corporation who has to pay tax to the government based on their income, and in the technical sense, they are liable for, or subject to or obligated to pay tax to the government based on the country’s tax laws.read more nor does it reduce the revenue of the government.Consumption tax is levied at the time of purchase of product or service; income tax is filed by the payeePayeeA payee refers to a person, business, government, or any other entity that receives payment for providing goods or services.read more before the deadline given by the government to pay the taxes.

Advantages

Poor is not burdened by the heavy taxes on the products as the higher taxes on luxury items compensate for it.Since more spending results in paying more tax, it encourages the activity of saving in the economy.Tax neutrality can be achieved effectively if this tax is levied appropriately across the economy.It is easy to estimate the spending in the economy and to calculate GDP using the expenditure method.GDP Using The Expenditure Method.The Expenditure Approach is one of the methods for calculating a country’s Gross Domestic Product (GDP) by adding all of the economy’s spending, including consumer spending on goods and services, investment spending, government spending on infrastructure, and net exports.read moreIn this, everyone pays a similar amount as tax for products coming under the same genre. There is no disparity in the tax amount paid.

Disadvantages

It can discourage consumer spending as it taxes more on spending more in an economy.To report and track, it is difficult from the government perspective compared to the income tax.Consumption tax on luxury products is very high; this will increase the price of the products in the market. It can lead to a reduction in demand.To make this work, everything and anything being sold in the economy has to be taxed. It will just increase the price and decrease the demand, ultimately reducing the spending in the economy.Retired individuals could be taxed twice because of this tax, which is a burden on the individual.In some scenarios, even the poor will end up paying more taxes than they can afford. It can be because of its lousy execution.

Conclusion

Consumption tax is a tax levied on spending in an economy. The idea is to neutralize the effect of tax on basic products by taxing luxury products more. In this way, the poor can benefit from an economy. It taxes individuals who can afford more and gives the benefit to the poor by taxing basic necessity products less.It is a concept of the west slowly making its way into the east. Having said that, in this tax, every product has to be taxed separately and appropriately so that it doesn’t burden the poor and also doesn’t damage the demand for the products. The ideology is to keep the government revenue intact without disturbing the economies of products. It has to be executed carefully in a particular economy to reap the advantages.

What is a Consumption Tax?#

Explanation#

Features#

How does it Work?#

Example#

Consumption vs. Income Tax#

Advantages#

Disadvantages#

Conclusion#

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